SEC Issues Guidance on Digital Asset Securities Regulatory Framework

News and Analysis

The U.S. Securities and Exchange Commission (SEC) has just released a statement on the regulatory status of digital assets, providing a new unofficial framework for identifying and recognizing potential security tokens/coins.

The public statement is released by the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub) and is said “to assist those seeking to comply with the U.S. federal securities laws.” The document is considered an unofficial framework for “analyzing whether a digital asset is offered and sold as an investment contract, and, therefore, is a security.”

Key Points

  • Forcefully limiting supply or ensuring scarcity, such as through token burns and buybacks can be considered ‘Reliance on the Efforts of Others’ potentially satisfying a condition of the ‘Howey Test.’
  • If a core team is mostly responsible for the development and growth of the digital asset value, so as to present a reasonable expectation of profit for its holders, then the asset may be a security.
  • If the digital asset price is solely, or mostly driven by external market forces, then this not usually considered a reasonable expectation of profit.
  • If the digital asset was previously a security, but now no longer appears to be one, e.g. if the development efforts of the team no longer leads to a reasonable expectation of profit, then it may need to be re-evaluated.

The case “Securities and Exchange Commission v. W. J. Howey Co.”, which was heard by the U.S. Supreme Court in 1946, resulted in a test, which later became known as the “Howey test”, to determine” whether an instrument qualifies as an ‘investment contract’ for the purposes of the Securities Act.”

According to this test, an “investment contract” exists “when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” FinHub says that the Howey analysis “is not only on the form and terms of the instrument itself” but “also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales).” So, “issuers and other persons and entities engaged in the marketing, offer, sale, resale, or distribution of any digital asset will need to analyze the relevant transactions to determine if the federal securities laws apply.”

Next, FinHub’s guidance note talks about application of Howey to digital assets, and examines each of the three required elements of the Howey test:

The Investment of Money: “The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration.”

Common Enterprise: “Courts generally have analyzed a ‘common enterprise’ as a distinct element of an investment contract. In evaluating digital assets, we have found that a “common enterprise” typically exists.”

Reasonable Expectation of Profits Derived from Efforts of Others: “Usually, the main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realize a return through participating in 3 distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. When a promoter, sponsor, or other third party (or affiliated group of third parties) (each, an ‘Active Participant’ or ‘AP’) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts, then this prong of the test is met.”

The main difficulty in determining if a digital asset is a security comes when trying to decide if the “Reasonable Expectation of Profits Derived from Efforts of Others” part of the Howey test is satisfied. Although the guidance note takes a detailed look at this, it still does not make it easy for crypto companies or their lawyers to apply the Howey test because it is possible to take one digital asset and for two lawyers to come up with conflicting answers to the question of whether that asset is a security or not since things are not always black and white.

The SEC maintains that while the framework is designed to help identify whether a digital asset or company should be subject to federal securities laws, it is ‘not a rule, regulation, or statement of the Commission’ — in essence, the framework is simply a clarification, rather than actual regulation.

The TurnKey Jet Case

Additionally, the SEC has issued a “no-action” letter to TurnKey Jet, Inc., agreeing that tokens used by the business-travel startup are not securities. The regulatory stamp of approval is contingent upon the company using its tokens under certain conditions.

Those conditions include:

  • Token-generated funds cannot be used to develop the company’s platform technology (such as its app).
  • The tokens will be immediately useful.
  • The TKJ tokens will remain at a fixed price of one U.S. dollar.
  • The tokens can only be used for air charter services.
  • Repurchases will only be made at a discount to the token.
  • TurnKey Jet will not represent the tokens as having profit potential.
  • TurnKey Jet is an air charter and air taxi service based in the United States, operating from West Palm Beach, Florida, since 2012.

The letter comes in reply to a letter from James P. Curry, counsel for TurnKey Jet, and has been signed by Jonathan A. Ingram of the SEC’s Division of Corporate Finance.

Perhaps the most interesting provision requires that the tokens not be transferable. The SEC’s letter says, “TKJ will restrict transfers of Tokens to TKJ Wallets only, and not to wallets external to the Platform.”

TurnKey Jet is a Florida company, domiciled in Delaware, that has been in operation since 2012, according to Curry’s letter. The company describes a number of inefficiencies in its industry that it believes smart contracts can help solve.

TurnKey’s letter goes into some detail about the token’s use:

“Redeemable for air charter services, the proposed Tokens in operation will be like the business jet card programs that are common in the aviation industry today.”

TurnKey further asserts that these tokens will not obligate the company to provide service at any cost; rather, one TKJ will represent one USD worth of fees. All outstanding tokens will be fully backed by an equal amount of fiat in an FDIC-insured institution, the company writes.

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